Naked Short Selling Rule - It's a Buy Signal!

By The Greek"

The SEC today extended its naked short selling rule to all stocks, and made it near permanent on an "interim final basis." The SEC will allow for a 30 day comment period, but clearly prefers to make this a permanent rule of law. Folks, I cannot understate the importance of this. It's a significant positive catalyst, and may help near-term lows mark the new market bottom.

(Article interests AMEX: DIA, AMEX: SPY, AMEX: QLD, AMEX: SDS, AMEX: DOG, NYSE: NYX, Nasdaq: QQQQ, NYSE: AIG, NYSE: BCS, NYSE: JPM, NYSE: BAC, NYSE: MS)

This naked shorting decision by the Securities and Exchange Commission, slated to take effect on Thursday in the early AM, should add much support to stocks by eliminating significant existing pressure against the market. The emergency rule that had been established for specific stocks in the financial sector expired on August 12, but the related pressure upon the shares of many companies, especially those in the financial sector, has helped to force several securities sharply lower and some firms out of business since. Thus, the SEC saw need to extend the rule to all stocks.

The rule makes perfect sense also, since equilibrium is restored to markets. There cannot now be an imbalance in theory; you should not be able to sell short on shares you do not own, or borrow against them, even when a broker is willing to cover for you. Thus, argument against naked shorting was well-founded. That reality made the existing situation clearly faulty, and this change is late in coming.

Hedge Fund Repercussions

Hedge funds are a whole lot less sexy as of today. Long/short investment strategies will be less efficient, and those portfolio managers will have much less flexibility. Portfolio risk/return opportunity will be severely damaged for the pure long/short equity gamers. Arbitrage opportunities are always limited, and this game had its day as well. The best and brightest managers will still produce returns, but the means will change. That said, I would look toward reducing weighting in long/short pure play funds now.

The specifics of the new rule are as such:

1. As of 12:01 a.m. ET on September 18, 2008, commission actions previously applied to only securities of financial firms with access to the Federal Reserve's Primary Dealer Credit Facility will now be extended to the securities of all publicly traded firms.
2. Short sellers and their brokers must now deliver securities by the close of business on the settlement date. Penalties will be imposed for failure to do so.
   
3. Violations will result in the broker being restricted from further short-sales in the specific security, unless the shares are located and pre-borrowed (meaning you have to deposit the shares before you short sell if your client screws up, and you can't cover for him).
   
4. Options market-makers will be treated equally, according to the new rule, whereas under the emergency restriction they were given exemption.
5. Violation of the new short-selling rule is a violation of law and will be penalized as such.
   

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